Articles

Psychology: The Role of Emotions in Investing

Everybody seems to “know” that getting emotional about investment decisions and market fluctuations is a bad idea. However, when it comes to making investments, human psychology often plays a large role and investors have a difficult time keeping emotions out of it. It goes without saying that this type of “emotional investing” can lead to very negative consequences.

One of the most common examples of emotions posing an obstacle to smart investment decisions is when it comes to “risk tolerance.” At the first sign of discomfort, many investors run to “adjust their risk levels.” I believe that it is more prudent to avoid this temptation. Because “risk tolerance” is a concept derived from our emotions, and not our intellect, this is every bit as volatile as any human emotions.

Successful investing is to a large extent managing our emotions, which often prompt change at precisely the wrong time.

People also change their “risk tolerance” in reaction to, rather than in anticipation of, market movements, which confirm it is also a lagged response.

Another key observation is that individual investors react to market movements by altering their comfort and “risk tolerance” in line with market cycles rather than against the cycle as should be the case.

Let me explain. As stock prices rise – and especially as they rise sharply, which reduces stock value – the investor perceives that risk in those companies/markets is actually declining, when in fact it is rising.

Since price and value are inversely related, risk is greatest when prices are high; the opposite is equally true. As stock prices rise there is less and less substance supporting the advance. Hence, the curve of a rising stock market is synonymous with rising risk.

Top -performing equities and mutual funds continually demonstrate this counterintuitive trend. Remember Nortel? At its peak people could still not buy enough. And the reverse remains true, which is when the individual investor no longer wants to own stocks and it is precisely at this moment that you can be sure we’re approaching the point of maximum financial opportunity. Just ask Warren Buffett or Peter Lynch when they get excited. It’s certainly not at market tops; that’s for sure.

The following chart illustrates the importance of managing our emotions when investing. Notice that if you relied solely on your emotions, you would drive yourself out of the market just before the point of maximum financial security. As our emotions become more negative, we often forget the bigger picture:

Human nature will ensure that this trend lives on, but through us you have the opportunity to disassociate emotional investment decisions by allowing us to invest professionally and ensure long-term success.